Month: March 2018

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Your Startup Is At Risk – Take Care of Your Compliance

When you’re running a start-up, envisioning the phone call that starts “hello sir, this is John, the head of M&A at Google” you are mostly concerned about product development and expansion in the market, and raising funds to allow such product development and expansion in the market.

Expanding means having your sales team travel around the nation and creating withholding liabilities all around. Salesperson traveling between states may cross states’ de-minimis rules of one or more states that may require your start-up to withhold taxes in those states. It may also result in filing requirements for these employees in more than one state. And you as the employer may have been required to inform the employees of such filing requirements.

Now, imagine that that call from John had come in, and John and his team is willing to start that due-diligence process, and to submit you with an investment agreement. One of the representations that you likely be required to provide in the agreement is “The Company had filed, or caused to be filed, all Tax Returns that the Company is required to file, and ALL SUCH TAX RETURNS ARE TRUE, COMPLETE, AND ACCURATE”. It will also include the following representation “The Company had paid all Taxes due, whether shown or not in the Tax Returns to the applicable taxing authorities, including through withholding.”

Now, can you make these representations? Has your company complied with the relevant and complex withholding tax rules in the varsity of states its sales personnel had traveled to? If you can’t make sure representation, how will it affect the investment and John’s team appetite to invest?

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State Tax Withholding – What You Should Know?

In addition to the federal tax rules, every State in the US is sovereign to adopt and administer its own tax rules. Out of the 50 US states, only 7 are income tax-free states. Florida, Nevada, Alaska, Texas, Wyoming, Washington, South Dakota. California is the highest-rate state with a whopping 13.3% rate, New York has 8.9% (and additional 3.9% for individual living in New York City.

In general, the underlying fundamental of the states tax rules is quite similar – you pay tax on your worldwide income to your state of residency (WE WILL HAVE A POST ON RESIDENCY), and you pay tax on your income that is earned in the source state, irrespective of your residency status in that state.

So for example, if you reside in New Jersey and worked in New York for certain number of days, you are taxed in New York on your income earned there, and you are also taxed in New Jersey on the same income (and all of your other income), because you reside in New Jersey. To avoid paying tax twice on the same income, states adopt a tax credit system in which your residency state allows you as a credit taxes paid at the source state.

Many states have agreements with other states pursuant to which the source state forgoes its taxing rights as a source state, and transfers the taxing right to the residency state. These are called reciprocity agreements. Many states have not entered into such agreements, for example, New Jersey. New York and Connecticut, do not have reciprocity agreements among them, although the geographic proximity. Therefore, taxpayers are often required to comply with more than one state’s tax laws.

To ease on the administrative burden, many states adopted rules to provide for a de-minimis threshold, for light travelers or to immaterial income earned in such state. Imagine your job requires you to travel often and to many states and that you crossed the de-minimis threshold in several of the states you traveled to? Consequently, you may be required to file a tax return and pay tax in more than one states. Now imagine that you didn’t know about your filing requirement. This can be expensive, and unpleasant.

Employee –

Imposition of penalties, interest and addition to tax.

Employees are required to file tax returns in every state in which they earned income (or to which their income is allocated). However, most states exempt you from filing tax returns, if the allocable income to such state is below the state’s minimum taxable income (mostly determined by the state’s personal exemption amount). Failure to file tax returns may result in i

Employer –
Employers are also required to comply with state tax rules that apply to employee compensation. Employees are required to withhold tax from the allocable portion of the employe’s compensation to each state the employee had worked into the extent the employee’s presence in such state resulted in crossing the de-minimis threshold. The consequences of failure to properly withhold and pay taxes to the relevant states may have a significant effect on the employer. There are interest and penalties associated with under withholding, there is a risk of state tax authorities audit, and non-curable double tax. Importantly, a failure to comply with state withholding tax requirements can have a major effect on the company’s ability to raise funds, to enter into a successful M&A, to undergo IPO, and to maximize valuation.

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Bye Bye Escrow.

You just sold your startup, what is the connection between your escrow and tax withholding.

 

When a company undergoes an investment round, M&A, or secondary purchase, it is customary to find in the investment or purchase agreement an amount of the purchase price (between 5%-15% of the purchase price) that remains in escrow for a couple of years, to make sure the buyer has funds retained to cover unexpected or overlooked expenses related to pre-closing periods.

One of such expenses is under-withholding of tax from employees’ compensation (which includes not only base salary and bonuses, but it also includes other fringe benefits, stock or stock options). If you overlooked the withholding requirements in states you were required to withhold and pay, that escrowed amount may be gone, it may also require you to indemnify the buyer, if the amount of tax, interest, and penalties (SEE BLOG ON THAT) exceeds the amount that is in escrow, and you gave a representation that all taxes have been paid (SEE BLOG FOR THAT).

 

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I’ll Take the Audit Risk Then. Really? Will you?

When you get a letter from state tax authority that it initiates a withholding audit, you say to your self, “ then God I’m using that prestigious payroll company”. The problem is that the tax authorities do not care about the taxes withheld, they are interested in the taxes you have not withheld. They care about your out-of-state employees (non-resident employees) that came over for a few days of work, and they care about out-of-state employers which employees are traveling to the state for work.

hat will you choose? If you choose the former, you may pay more than what you really owe (or less), if you choose the latter, you will have examiners at your business for a long period of time, going through hundreds of documents causing you a tremendous amount of legal fees.

 

 

So, what happens when you get that audit letter. A lot. You need to engage payroll, you need to engage HR, and you need to engage state counsel, your accountant and a lot of attention.

 

 

The state tax auditors will perform their audit by examining employees colanders, cell phone call reports, EZ-Pass, and credit card (expense report). They will check if and to what extent employees visited in that state to calculate the days visited in (or the amount of income allocated to) that state. After concluding the result, a deficiency letter may be issued (well, it may not be issued if you are among the 30% businesses in the US that somewhat comply with the complex withholding tax rules). In the deficiency letter, they will include the amount of tax, interest and penalties are owed to that state. In most cases, the examiners will only audit a few (or a few more than a few) employees and extrapolate the rate of deficiency to the entire amount of compensation paid to your employees. You can now choose, except that extrapolation, or demand the tax authority to conduct an audit on all of your employees. W

 

So, will you take the audit risk?

 

Let me tell you a personal note (as a former tax authority examiner), the worst thing for an examiner is to find out that during an audit that the taxpayer you’re auditing has complied with all the complex withholding rules. Here the examiner reaches a not so good of ROI (of time).

 

So, still thinks it makes sense to take the audit risk?

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When? and Where? – Withholding Tax De Minimis

De Minimis

Traveling for business to a state that is not your primary working state exposes the traveler employee to taxation and to filing requirements in that state, and also exposes the employer to withhold and pay to that state its allocable share of the overall withholding tax deducted from the employee’s income. Basically, states can tax traveler employees’ income from the first Dollar allocated to that state, however, to ease on the administrative burden, many states adopted rules to provide for a de-minimis threshold, for light travelers or to immaterial income earned in such state. Some states also entered into reciprocity agreements on which we will discuss in a separate post.

States adopted different and unrelated de-minimis rules, which, if you have several employees that travel to more than one state, requires the employer to comply with many different rules, guidelines and policies.

 

Here are some examples of the de-minimis rules applicable in 2018:

 

State Criteria Policy
New York First day of travel Only after 14 days of travel
Connecticut First day of travel Only after 15 days
New Jersey First day of travel
Pennsylvania First day of travel First $ earned within state
California $ amount ($1,500)
South Carolina $ amount ($1,000)
Maine 10 days
Ohio 20 days
Georgia 23 days OR $5,000 Or 5% of total income
Utah 60 days

 

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